WEEKEND READ: How not to lose everything

A former Merrill Lynch analyst explains how the clever deal making of CEO John Thain saved it from total oblivion.

Over the past year, Merrill Lynch and Lehman Brothers have provided a crash course in how to destroy century-old Wall Street firms. One company's shareholders are walking away with a $US50 billion consolation prize in the form of a merger with Bank of America, however, and the other's are getting hosed.

The difference is that Merrill Lynch's CEO, John Thain, played his cards wisely, while Lehman's CEO, Dick Fuld – along with the CEOs of Bear Stearns, Fannie Mae, Freddie Mac, Washington Mutual, and many other financial-services companies – didn't.

Merrill's Thain is a former president of Goldman Sachs and CEO of the New York Stock Exchange. He was brought into Merrill last year to fix the damage wrought by his predecessor, Stan O'Neal, the man who bears primary responsibility for Merrill's collapse. Thain's decisions can't be evaluated without understanding what he found when he got there, so here's some quick history.

O'Neal took over Merrill in late 2001, a few months before I left (I'd been a tech-stock analyst in the firm's research department since 1999). Merrill had previously been run by a charming bull of a man named David Komansky (think Tony Soprano meets Ralph Kramden), who was the last in a line of CEOs who oversaw a familial culture known as "Mother Merrill."

Merrill's ranks during the Komansky years were as hefty as he was, and O'Neal's first move upon seizing power was to fire about one-third of the firm. He replaced most of Merrill's senior managers with younger, more aggressive executives. He moved away from steady, fee-based businesses in favour of riskier origination and trading. And he took more risks with the firm's capital.

For several years, O'Neal's strategy was phenomenally successful. In rising markets, the firm minted money, and its stock soared to almost $100 a share. When the real-estate market finally broke, however, the subprime-mortgage securities and other products Merrill had been selling began to pile up on its balance sheet. A few quarters later, when the value of these securities had plunged, Merrill was forced to take a massive write-off, and Stan O'Neal was gone.

Enter John Thain.

When Thain arrived at Merrill, he did what almost every incoming CEO does: flushed the memory of his predecessor with another massive write-off. Thain also raised billions of dollars of new capital to replace the money O'Neal's mortgage-gambling operation had lost. When he finished with this housecleaning, Thain pronounced his new firm in solid shape. And, for a few minutes, it was.

Over the next few quarters, however, as the real-estate and credit markets slid toward the worst financial crisis since the Great Depression, the value of Merrill's assets continued to deteriorate. Soon analysts began to clamour that Thain hadn't done enough, that the firm needed to take more write-offs and raise more capital.

The same thing, of course, was happening across the entire financial-services industry. Thain, in other words, had been dealt a tough hand, but, unlike his compatriots at Bear, Lehman, Fannie, Freddie, and other firms, he played it well. Specifically, instead of blaming sceptics and short-sellers for Merrill's sagging stock price, Thain focused on strengthening the firm's balance sheet. Several times over the next few quarters, he swallowed his pride, took more enormous write-offs, and raised even more capital.

Over at Lehman, meanwhile, CEO Dick Fuld was dealing with the same problems and implementing the same solutions – but always a step behind.

Unlike Thain, Fuld hadn't been brought in to fix Lehman – he had built it. So, making the aggressive "de-risking" moves Thain was making would have meant dismantling his own aggressive growth and leverage strategy. It's unclear whether it was a reluctance to own up to his own mistakes that doomed Fuld or just a failure to recognize how rapidly the markets were deteriorating. Regardless, toward the end of last week, when Fuld finally realized how far up a creek he and Lehman were, it was too late.

The events of last weekend will forever be seared in Wall Street history. To have not one but two major brokerage firms nearly fail at the same time has, to my knowledge, never happened before, not even after the crash of 1929, and it's not likely to ever happen again.

Going into the weekend, Merrill's stock had already fallen to $17. By Sunday afternoon, with Lehman's last hope to save itself having fallen through, it seemed as though the resulting market carnage might take Merrill right down to zero.

Once again, however, Thain played his weak cards wisely. Instead of wasting another precious day explaining to investors why the market was wrong and the firm's balance sheet was strong, Thain acted. And this time, he fixed Merrill's problem once and for all.

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